While the Iraqi people struggle to define their future amid political
chaos and violence, the fate of their most valuable economic asset,
oil, is being decided behind closed doors.

This report reveals how an oil policy with origins in the US State
Department is on course to be adopted in Iraq, soon after the December
elections, with no public debate and at enormous potential cost. The
policy allocates the majority (1)
of Iraq’s oilfields – accounting for at least 64% of the country’s oil
reserves – for development by multinational oil companies.

Iraqi public opinion is strongly opposed to handing control over oil
development to foreign companies. But with the active involvement of
the US and British governments a group of powerful Iraqi politicians
and technocrats is pushing for a system of long term contracts with
foreign oil companies which will be beyond the reach of Iraqi courts,
public scrutiny or democratic control.

COSTING IRAQ BILLIONS

Economic projections published here for the first time show that the
model of oil development that is being proposed will cost Iraq hundreds
of billions of dollars in lost revenue, while providing foreign
companies with enormous profits.

Our key findings are:

At an oil price of $40 per barrel, Iraq stands to lose between
$74 billion and $194 billion over the lifetime of the proposed
contracts (2), from only the
first 12 oilfields to be developed. These estimates, based on
conservative assumptions, represent between two and seven times the
current Iraqi government budget.

Under the likely terms of the contracts, oil company rates of return
from investing in Iraq would range from 42% to 162%, far in excess of
usual industry minimum target of around 12% return on investment.

A CONTRACTUAL RIP-OFF

The debate over oil "privatisation" in Iraq has often
been misleading due to the technical nature of the term, which refers
to legal ownership of oil reserves. This has allowed governments and
companies to deny that "privatisation" is taking place. Meanwhile, important
practical questions, of public versus private control over oil development
and revenues, have not been addressed.

The development model being promoted in Iraq, and supported
by key figures in the Oil Ministry, is based on contracts known as production
sharing agreements (PSAs), which have existed in the oil industry since
the late 1960s. Oil experts agree that their purpose is largely political:
technically they keep legal ownership of oil reserves in state hands
(3), while practically delivering
oil companies the same results as the concession agreements they replaced.

Running to hundreds of pages of complex legal and financial
language and generally subject to commercial confidentiality provisions,
PSAs are effectively immune from public scrutiny and lock governments
into economic terms that cannot be altered for decades.

In Iraq’s case, these contracts could be signed while
the government is new and weak, the security situation dire, and the
country still under military occupation. As such the terms are likely
to be highly unfavourable, but could persist for up to 40 years.

Furthermore, PSAs generally exempt foreign oil companies
from any new laws that might affect their profits. And the contracts
often stipulate that disputes are heard not in the country’s own courts
but in international investment tribunals, which make their decisions
on commercial grounds and do not consider the national interest or other
national laws. Iraq could be surrendering its democracy as soon as it
achieves it.

POLICY DELIVERED FROM AMERICA TO IRAQ

Production sharing agreements have been heavily promoted
by oil companies and by the US Administration.

The use of PSAs in Iraq was proposed by the Future of
Iraq project, the US State Department’s planning mechanism, prior to
the 2003 invasion. These proposals were subsequently developed by the
Coalition Provisional Authority, by the Iraq Interim Government and
by the current Transitional Government. The Iraqi Constitution also
opens the door to foreign companies, albeit in legally vague terms.

Of course, what ultimately happens will depend on the
outcome of the elections, on the broader political and security situation
and on negotiations with oil companies. However, the pressure for Iraq
to adopt PSAs is substantial. The current government is fast-tracking
the process and is already negotiating contracts with oil companies
in parallel with the constitutional process, elections and passage of
a Petroleum Law.

The Constitution also suggests a decentralisation of
authority over oil contracts, from the national level to Iraq’s regions.
If implemented, the regions would have weaker bargaining power than
a national government, leading to poorer terms for Iraq in any deal
with oil companies.

A RADICAL DEPARTURE

In order to make their case, oil companies and their
supporters argue that PSAs are standard practice in the oil industry
and that Iraq has no other option to finance oil development. Neither
of these assertions is true.

According to International Energy Agency figures, PSAs
are only used in respect of about 12% of world oil reserves, in countries
where oilfields are small (and often offshore), production costs are
high, and exploration prospects are uncertain. None of these conditions
applies to Iraq.

None of the top oil producers in the Middle East uses
PSAs. Some governments that have signed them regret doing so. In Russia,
where political upheaval was followed by rapid opening up to the private
sector in the 1990s, PSAs have cost the state billions of dollars, making
it unlikely that any more will be signed. The parallel with Iraq's current
transition is obvious.

The advocates of PSAs also claim that obtaining investment
from foreign companies through these types of contracts would save the
government up to $2.5 billion a year, freeing up funds for other public
spending. Although this is true, the investment by oil companies now
would be massively offset by the loss of state revenues later.

Our calculations show that were the Iraqi government
to use PSAs, its cost of capital would be between 75% and 119%. At this
cost, the advantages referred to are simply not worth it.

Iraq has a range of less damaging and expensive options
for generating investment in its oil sector. These include: financing
oil development through government budgetary expenditure (as is currently
the case), using future oil flows as collateral to borrow money, or
using international oil companies through shorter-term, less restrictive
and less lucrative contracts than PSAs (4).

IN WHOSE INTERESTS?

PSAs represent a radical redesign of Iraq's oil industry,
wrenching it from public into private hands. The strategic drivers for
this are the US/UK push for "energy security" in a constrained market
and the multinational oil companies’ need to "book" new reserves to
secure future growth.

Despite their disadvantages to the Iraqi economy and
democracy, they are being introduced in Iraq without public debate.

It is up to the Iraqi people to decide the terms for
the development of their oil resources. We hope that this report will
help explain the likely consequences of decisions being made in secret
on their behalf.

Notes

1. The Iraqi government would be left
with control of only the 17 fields that are already in production, out
of around 80 known fields.

2. The precise terms of proposed contracts
are obviously be subject to negotiation: our projections are based on
a range of terms used in the most comparable countries, including Libya,
which is commonly viewed as having some of the most stringent in the
world. Multinational oil companies are pushing for lucrative terms by
international standards, based on Iraq’s high level of political and
security risk. These risks place the Iraqi government in an extremely
weak negotiating position. The projections are given in undiscounted
real terms (2006 prices). The contract duration is assumed to be 30
years as 25-40 years is the common length. The (2006) net present value
of the loss to Iraq amounts to between $16 billion and $43 billion at
12% discount rate.

3. The terminology of PSAs labels
the private companies as "contractors". This report illustrates that
this label is misleading because PSAs give companies control over oil
development and access to extensive profits.

4. These might include buyback contracts,
risk service contracts or development and production contracts

The UK and US have long had their eyes on the massive
energy resources of Iraq and the Gulf. In 1918 Sir Maurice Hankey, Britain’s
First Secretary of the War Cabinet wrote:

"Oil in the next war will occupy the place of coal in
the present war, or at least a parallel place to coal. The only big
potential supply that we can get under British control is the Persian
[now Iran] and Mesopotamian [now Iraq] supply… Control over these oil
supplies becomes a first class British war aim."(1)

After World War II both the US and UK identified the
importance of Middle Eastern oil. British officials believed that the
area was "a vital prize for any power interested in world influence
or domination"(2), while their
US counterparts saw the oil resources of Saudi Arabia as a "stupendous
source of strategic power and one of the greatest material prizes in
world history"(3).

TURNING BACK TO THE MIDDLE EAST

With over 60% of the world’s oil reserves,(4)
their interest in the Gulf region is unsurprising. Iraq alone has the
third largest oil reserves on the planet – accounting for 10% of the
world total. Iraq is also reckoned to have the world’s largest unexplored
potential, primarily in the Western Desert. On top of its 115 billion
barrels of proven reserves, Iraq is estimated to have between 100 and
200 billion barrels of further possible (as yet undiscovered) reserves.
Furthermore, not only are Iraqi and Gulf reserves huge, they are mostly
onshore, in favourable reservoir structures, and extractable at extremely
low cost.

Since the nationalisation of the major oil industries
of the Middle East in the 1970s, Gulf reserves have been out of the
direct control of the West and off the balance sheets of its companies.
The oil companies have filled the gap by moving into the North Sea and
Alaska in the 1970s and 1980s, and then in the 1990s by opening new
'frontier’ areas such as the Caspian Sea and offshore West Africa.

However, the North Sea and Alaska are now in decline
and while companies continue to actively pursue frontier oil development,
the opportunities for growth there are limited and costs high. Thus,
unable to escape from the arithmetic of where the giant reserves are,
the US and UK are turning back their attention to the Middle East.

In a speech to the Institute of Petroleum in London
in 1999, Dick Cheney, then CEO of oil services company Halliburton,
commented:

"By 2010 we will need on the order of an additional
fifty million barrels a day. So where is the oil going to come from?
... While many regions of the world offer great oil opportunities, the
Middle East with two thirds of the world's oil and the lowest cost,
is still where the prize ultimately lies."(5)

To this analysis, he added a note of frustration: "Even
though companies are anxious for greater access there, progress continues
to be slow".

A PRIMARY FOCUS OF US/UK ENERGY POLICY

Two years later, one of the Bush Administration’s first
actions was to appoint Cheney, as US Vice President, to lead an Energy
Task Force to consider where the USA’s long-term energy supplies would
come from. His report noted:

"By any estimation, Middle East oil producers will remain
central to world oil security. The Gulf will be a primary focus of U.S.
international energy policy."(6)

While US interest in Middle Eastern oil has been well-documented,
similar considerations play in British strategic planning too. In January
2003, Foreign Secretary Jack Straw announced that one of the Foreign
Office’s seven priorities was "to bolster the security of British and
global energy supplies".(7)
The geography of such a policy had been spelled out in the 1998 Strategic
Defence Review white paper:

"Outside Europe our interests are most likely to be
affected by events in the Gulf and the Mediterranean. Instability in
these areas also carries wider risks. We have particularly important
national interests and close friendships in the Gulf. Oil supplies from
the Gulf are crucial to the world economy."(8)

Pointing to the government’s partnership on these issues
with major oil companies, a further Foreign Office strategy paper later
in 2003 identified a key objective as to:

"improve investment regimes and energy sector management
in these regions [the Middle East, parts of Africa and the former Soviet
Union], focusing on key links in the supply chain to the UK"(9)
(emphasis added).

Importantly, these policies in America and Britain are
coordinated. The US-UK Energy Dialogue - a bilateral initiative established
during the April 2002 meeting of Prime Minister Blair and President
Bush in Crawford, Texas(10),
and designed to "enhance coordination and cooperation on energy issues"
- demonstrates the close convergence of Anglo-American views and interests
on Middle Eastern oil:

"Current forecasts for the oil sector put global demand
by 2030 at about 120 million barrels per day (mbd), which is roughly
45 mbd higher than today. While recognizing that the increasing role
of Russia and other non-OPEC producers, a large proportion of the world's
additional demand will likely be met by the Middle East (mainly Middle
East Gulf) producers. They hold over half of current proven reserves,
exploration and production costs are the lowest in the world, and production
in many mature fields in the OECD area is likely to fall. To meet future
world energy demand, the current installed capacity in the Gulf (currently
23 mbd) may need to rise to as much as 52 mbd by 2030."(11)

PUSHING FOREIGN INVESTMENT

However, as noted in the Dialogue, one obstacle to "free
access" to oil that concerns the British and Americans is the lack of
'installed extraction capacity’. To help deal with this problem President
Bush and Prime Minister Blair tasked a joint Working Group with a list
of planned activities. First on the list was to undertake "...a targeted
study to examine the capital and investment needs of key Gulf countries...".(12)

Within this context, it is perhaps unsurprising that
in advising on the post-war reconstruction of Iraq, the British government
has recommended that foreign investment in oilfields of most benefit
to Iraq. In late summer 2004, the Foreign and Commonwealth Office issued
a Code of Practice for the Iraqi oil industry, which argued that:

"It has been estimated that a minimum of US$ 4 billion
would be needed to restore production to its 1990 levels of 3.5 million
barrels per day (mbd), and perhaps US$ 25 billion to achieve 5 mbd.
... Given Iraq's needs, it is not realistic to cut government spending
in other areas, and Iraq would need to engage with the International
Oil Companies (IOCs) to provide appropriate levels of Foreign Direct
Investment (FDI) to do this."(13)

Photo: Greg
MuttittThe key US-UK "energy
security" priority is secure control over an increasing
supply of Gulf oil, preferably delivered by investment from
their own companies

The Foreign Office subsequently went on to advise
the Ministry of Oil on "fiscal and regulatory" issues.(14)
Although this was never published in a formal policy document, it
continued at an informal level, with Foreign Office minister Kim Howells
stating that "We discuss with the Iraqi Ministries their priorities
on a regular basis."(15)
The FCO remains secretive about the content of this advice, refusing
Freedom of Information applications. Tellingly, one of the exemptions
used for their refusal was that the advice was "voluminous".(16)

The US government too has maintained close contacts
with Iraqi decision-makers.(17)
Speaking on the handover from the Coalition Provisional Authority to
the Iraqi Interim Government, one senior US official said:

"We're still here. We'll be paying a lot of attention
and we'll have a lot of influence. We're going to have the world's largest
diplomatic mission with a significant amount of political weight."(18)

A report commissioned by the US Agency for International
Development was more specific about the form of contracts that should
be used in Iraq, in order to achieve the West’s energy security goals:

"Using some form of [production sharing agreements]
with a competitive rate of return has proved the most successful way
to attract [international oil company] investment to expand oil productive
capacity significantly and quickly."(19)

As the above policies illustrate, the key US-UK 'energy
security’ priority is secure control over an increasing supply of Gulf
oil, preferably delivered by investment from their own oil companies.
It is clear that Iraq's newly accessible oil is expected to play an
important role in meeting these priorities. But as we shall see, implementing
these arrangements could have severe impacts on Iraq’s future development.

Given the West’s fundamental strategic interest in the
oil reserves of Iraq and the Gulf as outlined in the previous section,
some observers were surprised when the oil sector was excluded from
the sweeping privatisations of Iraq’s economy by US Administrator Paul
Bremer in 2003 and 2004. Decisions on the future structure of the oil
industry were deferred, to be addressed by an elected Iraqi government.

The Coalition Provisional Authority only awarded short-term
repair and restoration contracts – for service companies such as Halliburton
and Parsons to restore the country’s existing oil infrastructure, which
had been damaged by war and sanctions – rather than long-term extraction
concessions. In February 2005, Interim Oil Minister Thamer al-Ghadban
stated that "As for the extraction sector, that is, dealing with the
oil and gas reserves, which are 'assets', privatisation is completely
out of the question at the moment."(20)

But if the non-privatisation of oil was a surprise,
this was largely based on a misconception of what "privatisation" means
in the Iraqi context. In the minds of some neo-conservatives, writing
on Iraqi oil before the war, privatisation meant the transfer of legal
ownership of Iraq's oil reserves into private hands. However, in all
countries of the world except the USA (a), reserves (prior to their extraction)
are legally the property of the state. This is the case in Iraq, and
remains so under the new Constitution. There has never been a realistic
prospect of US-style privatisation of Iraq’s oil reserves. But this
does not mean that private companies would not develop Iraq’s oil.

In some ways, the debate on "privatisation" has obscured
the important practical issues of who gets the revenue
from the oil, and who controls the way in which oil
is developed. On this matter, Iraq has a relevant history.

The development of Iraq’s oil industry began in the
aftermath of the First World War, while the country was occupied by
Britain under a League of Nations Mandate. In 1925, Iraq’s British-installed
monarch, King Faisal, signed a concession contract with the Iraq Petroleum
Company (IPC)(21), a consortium
of British, French and (later) American oil companies. The contract
followed a model widely applied in the British colonies. It was for
a period of 75 years, during which terms were frozen. Combined with
two further concessions granted in the 1930s, the IPC obtained rights
to all of the oil in the entire country. Even the Iraqi call for a 20%
stake in the concession was denied, despite having been specified in
earlier agreements.

As Iraqi frustration at the unfair terms of the deal
grew, in the 1950s and 1960s the contract came under pressure. Underpinning
this were the issues of whether the split of revenues between company
and state was a fair one, and the degree of control the foreign companies
had over the development: they restricted production to boost their
producing areas elsewhere in the world, and used their monopoly on information
to fix prices, depriving Iraq of income. These same arguments were echoed
in all of the major oil-producing countries at the time, most of which
had similar deals with multinational companies. The ultimate conclusion
to these disputes was the nationalisation of many oil industries – in
Iraq’s case in two stages in 1961 and 1972.(b)

INTRODUCING PRODUCTION SHARING AGREEMENTS

While these disputes were raging in the Middle East,
a different model was emerging in Indonesia. There, a new form of contract
was introduced in the late 1960s: the production sharing agreement
(PSA).

An ingenious arrangement, PSAs shift the ownership of
oil from companies to state, and invert the flow of payments between
state and company. Whereas in a concession system, foreign companies
have rights to the oil in the ground, and compensate host states for
taking their resources (via royalties and taxes), a PSA leaves the oil
legally in the hands of the state, while the foreign companies are compensated
for their investment in oil production infrastructure and for the risks
they have taken in doing so.

Although many in the oil industry were initially suspicious
of Indonesia’s move, they soon realised that by setting the terms the
right way, a PSA could deliver the same practical outcomes as a concession,
with the advantage of relieving nationalist pressures within the country.
In one of the standard textbooks on petroleum fiscal systems, industry
consultant Daniel Johnston comments:

"At first [PSAs] and concessionary systems appear to
be quite different. They have major symbolic and philosophical differences,
but these serve more of a political function than anything else. The
terminology is certainly distinct, but these systems are really not
that different from a financial point of view."(22)

So, the financial and economic implications of PSAs
may be the same as concessions, but they have clear political advantages
– especially when contrasted with the 1970s nationalisations in the
Middle East. Professor Thomas Wälde, an expert in oil law and policy
at the University of Dundee, describes them as:

"A convenient marriage between the politically useful
symbolism of the production-sharing contract (appearance of a service
contract to the state company acting as master) and the material equivalence
of this contract model with concession/licence regimes in all significant
aspects…The government can be seen to be running the show - and the
company can run it behind the camouflage of legal title symbolising
the assertion of national sovereignty."(23)

As we will see, these advantages now appear to make
PSAs the Western method of choice for future development of the Iraqi
oil industry.

OPTIONS FOR OIL POLICY

There are essentially three models a country may
choose from for the structure of its oil industry, plus a number
of variations on these themes.

1. The system currently in place in Iraq, which
has been the case since the early 1970s, is a NATIONALISED
INDUSTRY. In this model, the state makes all of the decisions,
and takes all of the revenue. The extent of involvement of foreign
private companies is that they might be hired to carry out certain
services under contract (a technical service contract) – a well-defined piece of work, for a limited period of time,
and for which they receive a fixed fee. This is the model used
throughout most of the Gulf region.

One variant on the technical service contract
is the risk service contract. In this system, a private
company provides capital to invest in a project, but is paid a
fixed rate of return, agreed in the contracts (thus preventing
excessive profits). A similar mechanism is the buyback contract,
which has been used on some fields in Iran, in which companies
also have a right to buy the oil or gas.

2. In the CONCESSION model, sometimes
known as the tax and royalty system, the government grants a private
company (or more often, a consortium of private companies) a license
to extract oil, which becomes the company’s property (to sell,
transport or refine) once extracted. The company pays the government
taxes and royalties for the oil.

3. The PRODUCTION SHARING AGREEMENT (PSA)
is a more complex system. In theory, the state has ultimate control
over the oil, while a private company or consortium of companies
extracts it under contract. In practice, however, the actions
of the state are severely constrained by stipulations in the contract.
In a PSA, the private company provides the capital investment,
first in exploration, then drilling and the construction of infrastructure.
The first proportion of oil extracted is then allocated to the
company, which uses oil sales to recoup its costs and capital
investment – the oil used for this purpose is termed 'cost oil’.
There is usually a limit on what proportion of oil production
in any year can count as cost oil. Once costs have been recovered,
the remaining 'profit oil’ is divided between state and company
in agreed proportions. The company is usually taxed on its profit
oil. There may also be a royalty payable on all oil produced.

Sometimes the state also participates as a commercial
partner in the contract, operating in joint venture with
foreign oil companies as part of the consortium – with either
a concession or a PSA model. In this case, the state generally
provides its percentage share of development investment and directly
receives the same percentage share of profits.

As with many issues of foreign policy, the interests
of the world’s largest oil corporations mesh closely with those of their
national governments – as we saw in section 1. While the governments
seek secure and adequate supplies of oil to feed their economies, the
corporations need control over reserves to ensure their future profitability,
to deliver returns to their shareholders. For governments, "secure"
oil supplies often means that they are in fact part-controlled by major
oil corporations based in their own countries.

For their part, major multinational oil companies have
made no secret of their desire to gain access to Iraq’s reserves. Shortly
before the invasion Archie Dunham, chairman of US oil major ConocoPhillips,
explained that "We know where the best [Iraqi] reserves are [and] we
covet the opportunity to get those some day."(24)
Shell has stated that it aims to "establish a material and enduring
presence in the country."(25)

Since the overthrow of Saddam Hussein, foreign oil companies
have worked hard to build relationships with Iraq’s Oil Ministry. They
have appointed lobbyists to develop relationships with influential officials,
provided training (often for free) for Iraqi officials and technicians,
sponsored Oil Ministry participation in international conferences, and
entered contracts (again, often for free) to analyse oilfield geological
data.

In 2004, Shell recruited an Iraqi external affairs officer
to help the company gain access to Iraqi government decision-makers,
specifying in their advertisement:

"A person of Iraqi extraction with strong family connections
and an insight into the network of families of significance within Iraq".(26)

Through these means, the companies aim to be well-positioned
when it comes to the signing of contracts.

WHAT OIL COMPANIES WANT

It is helpful at this point to look at the companies’
agenda for Iraq. Oil corporations are looking for three things when
they invest in a country, all of which are delivered by production
sharing agreements:

Photo: Greg Muttitt
Oil companies covet Iraq's oil wealth, and are pushing for access
to it through production sharing agreements

1. A right to oil reserves. Companies want a
deal that guarantees their right to extract the reserves for many years,
thus ensuring their future growth and profits. Furthermore, they want
a contract that allows them to 'book’ these reserves – including them
in their accounts – which increases their company value. Production
sharing agreements, like concession contracts, permit companies to book
reserves in their accounts. The importance of this should not be underestimated
for the oil majors. In 2004, when British/Dutch oil company Shell was
found to have overstated the size of its 'booked’ reserves by over 20%,
it lost the faith of the financial markets: this impacted heavily on
its share price and credit rating. Shell is now desperate to acquire
new reserves – which is a key reason why Shell has made more effort
than most to make friends in Iraq.

2. An opportunity to make large profits. Generally,
oil companies make their profits from investing and risking their capital.
In some cases, they lose their capital, for example when they drill
a 'dry well’. But in some cases they will find large and hugely profitable
fields. Oil companies are therefore very different from service companies
like Halliburton, which make money from fixed fees on predictable contracts.
Oil companies aim for deals which may be more speculative, but which
give them a chance of making super-profits. Production sharing agreements
are designed to allow companies to achieve very large profits if successful.

3. Predictability of tax and regulation. While
companies can accept exploration risk (that they won’t find oil) or
price risk (that the oil price falls), both being beyond their control,
they try to manage 'political risk’ (that tax or regulatory demands
will increase) by locking in governments. They thus seek to bind governments
into long-term contracts that fix the terms of their investment. Production
sharing agreements generally last for 25 to 40 years with terms protected
from potential change by incoming governments.

Shell’s head of Exploration & Production, speaking at
a conference in 2003, made the case for PSAs:

"...international oil companies can make an ongoing
contribution to the region [the Persian/Arabian Gulf]... However, in
order to secure that investment, we will need some assurance of future
income and, in particular, a supportive contractual framework. There
are a number of models which can achieve these ends. One option is the
greater use of production sharing agreements, which have proved very
effective in achieving an appropriate balance of incentives between
Governments and oil companies. And they ensure a fair distribution of
the value of a resource while providing the long term assurance which
is necessary to secure the capital investment needed for energy projects."(27)

THE VOICE OF BIG OIL

The most detailed expression of what the oil companies
are seeking in Iraq has been made by the International Tax & Investment
Centre (ITIC), a corporate lobby group pushing for pro-business investment
and tax reform.

Almost all of ITIC's 110 listed sponsors are large corporations,
with roughly a quarter of these in the oil sector. ITIC’s Board of Directors
contains representatives from Shell, BP, ConocoPhillips, ExxonMobil
and ChevronTexaco. Since its launch in 1993, ITIC has primarily focused
on the former Soviet Union, but more recently, it has expanded its work
to include Iraq. Its 2004 strategy review concluded that this project
"should be continued and considered as a "beachhead" for possible further
expansion in the Middle East."(28)

In autumn 2004 ITIC issued a major report entitled Petroleum
and Iraq's Future: Fiscal Options and Challenges, which includes the
following key recommendations:

"The most appropriate legal and
fiscal form for the facilitation of [Foreign Direct Investment]
longer-term development of Iraq's petroleum industry will be a
production sharing agreement (PSA)."(29)

Foreign Direct Investment, by ITIC members and other multinational oil companies,
would "effectively "kick start" the [Iraqi] economy and avoid the government
diverting spending to oil development that is sorely needed for other
programmes."(30)

PSAs are lauded as providing the "simplest and most
attractive regulatory ... framework" which the ITIC claims are now the
"norm in most countries outside the OECD."(31)
Having reviewed the various options, with due consideration to "international
experience and regional preferences", the ITIC concludes that the alternative
models are far inferior to PSAs.

INAPPROPRIATE FOR IRAQ

PSAs are indeed quite common in countries with small
oil reserves and/or high extraction costs (especially from offshore
fields) and/or high exploration or technical risks. However, none of
these conditions apply to Iraq; in fact, Iraq is quite the opposite.
PSAs are not found in any other country comparable to Iraq.

It is difficult to overstate how radical a departure
PSAs would be from normal practice, both in Iraq and in other comparable
countries of the region. Iraq’s oil industry has been in public hands
since 1972; prior to that the rights to develop oil in 99.5% of the
country had also been publicly held since 1961.(c)

In Iraq’s neighbours Kuwait, Iran and Saudi Arabia,
foreign control over oil development is ruled out by constitution or
by national law. These countries together with Iraq are the world’s
top four countries in terms of oil reserves, with 51% of the world total
between them.(32)

Together with the United Arab Emirates, Venezuela and
Russia, seven countries hold 72% of the world’s oil reserves. These
latter three all have some foreign involvement through concession agreements,
although both Venezuela and Russia are currently drawing back from it,
following unsuccessful expansions in foreign investment in the 1990s.
Of these seven countries with major oil reserves, only Russia has any
production sharing agreements. Russia signed three PSAs in the mid 1990s;
however, PSAs have been the subject of extreme controversy ever since,
due to the poor deal the state has obtained from them, and it now looks
unlikely that any more will be signed.

Countries with reserves the size of Iraq’s do not use
PSAs because they do not need to and are able to run their oil industries
on far more beneficial terms.

Current Iraqi oil
policy - first designed in
Washington, DC - would give at least 4% of Iraq's reserves to foreign
companies

Prior to the 2003 invasion, the principal vehicle for
planning the new post-war Iraq was the US State Department’s Future
of Iraq project. This initiative, commencing as early as April 2002,
involved meetings in Washington and London of 17 working groups, each
comprised of 10-20 Iraqi exiles and international experts selected by
the State Department(33).

The "Oil and Energy" working group met four times between
December 2002 and April 2003. Although the full membership of the group
has never been revealed, it is known that Ibrahim Bahr al-Uloum, the
current Iraqi Oil Minister, was a member.(34)
The 15-strong oil working group concluded that Iraq "should be opened
to international oil companies as quickly as possible after the war"
and that "the country should establish a conducive business environment
to attract investment of oil and gas resources."(35)

The subgroup went on to recommend production sharing
agreements (PSAs) as their favoured model for attracting foreign investment.
Comments by the handpicked participants revealed that "many in the group
favoured production-sharing agreements with oil companies." Another
representative commented, "Everybody keeps coming back to PSAs."(36)

The reasons for this choice were explained in the formal
policy recommendations of the working group, published in April 2003:

"Key attractions of production sharing agreements to
private oil companies are that although the reserves are owned by the
state, accounting procedures permit the companies to book the reserves
in their accounts, but, other things being equal, the most important
feature from the perspective of private oil companies is that the government
take is defined in the terms of the [PSA] and the oil companies are
therefore protected under a PSA from future adverse legislation."(37)

The group also made it clear that in order to maximize
investments, the specific terms of the PSAs should be favourable to
foreign investors:

"PSAs can induce many billions of dollars of foreign
direct investment into Iraq, but only with the right terms, conditions,
regulatory framework, laws, oil industry structure and perceived attitude
to foreign participation."(38)

Recognising the importance of this announcement, The
Financial Times noted:

"Production-sharing deals allow oil companies a favourable
profit margin and, unlike royalty schemes, insulate them from losses
incurred when the oil price drops. For years, big oil companies have
been fighting for such agreements without success in countries such
as Kuwait and Saudi Arabia."(39)

The article concluded that: "The move could spell a
windfall for big oil companies such as ExxonMobil, Royal Dutch/Shell,
BP and TotalFinaElf..."

SHAPING THE NEW IRAQ

The US and UK have worked hard to ensure that the future
path for oil development chosen by the first elected Iraqi government
will closely match their interests. So far it appears they have been
highly successful: production sharing agreements, which were first proposed
by the U.S. State Department group, have emerged as the model of oil
development favoured by all the post-invasion phases of Iraqi government.

Phase 1: Coalition Provisional Authority and
Iraqi Governing Council

During the first fourteen months following the invasion,
occupation forces had direct control of Iraq through the Coalition Provisional
Authority. Stopping short of privatising oil itself, the CPA began setting
up the framework for a longer-term oil policy.

The CPA appointed former senior executives from oil
companies to begin this process. The first advisers were appointed in
January 2003, before the invasion even started, and were stationed in
Kuwait ready to move in. First, there were Phillip Carroll, formerly
of Shell, and Gary Vogler, of ExxonMobil, backed up by three employees
of the US Department of Energy and one of the Australian government.
Carroll described his role as not only to address short-term fuel needs
and the initial repair of production facilities, but also to:

"Begin planning for the restructuring of the Ministry of Oil to improve its efficiency and effectiveness; [and]

Begin thinking through Iraq’s strategy options for significantly increasing its production capacity."(40)

In October 2003, Carroll and Vogler were replaced by
Bob McKee of ConocoPhillips, and Terry Adams of BP, and finally in March
2004, by Mike Stinson of ConocoPhillips and Bob Morgan of BP (d).
The £147,700 cost of the two British advisers, Adams and Morgan, was
met by the UK government.(41)
Following the handover to the Iraq Interim Government in June 2004,
Stinson became an adviser to the US Embassy in Baghdad.

On 13 July 2003, in the first move towards Iraqi self-government, the
CPA Administrator Paul Bremer appointed the quasi-autonomous, but
virtually powerless, Iraqi Governing Council. On the same day Bremer
appointed Ibrahim Bahr al-Uloum, who had been a member of the U.S.
State Department oil working group, as Minister for Oil.

Within months of his appointment Bahr al-Uloum announced that he was
preparing plans for the privatisation of Iraq's oil sector, but that no
decision would be taken until after elections scheduled for 2005.(42)

Speaking to the Financial Times, Bahr al-Uloum, a US-trained petroleum
engineer, said: "The Iraqi oil sector needs privatisation, but it's a
cultural issue," noting the difficulty of persuading the Iraqi people
of such a policy. He then proceeded to announce that he personally
supported:

giving priority to US oil companies, "and European companies, probably."(43)

Phase 2: Iraq Interim Government

In June 2004, the CPA formally handed over Iraqi sovereignty to an interim government, headed by Prime Minister Iyad Allawi.

The position of Minister of Oil was handed to Thamir al-Ghadban, a
UK-trained petroleum engineer and former senior adviser to Bahr
al-Uloum. In an interview in Shell’s in-house magazine, al-Ghadban
announced that 2005 would be the "year of dialogue" with multinational
oil companies.(44)

About three months after taking power, Allawi issued a set of
guidelines to the Supreme Council for Oil Policy, from which the
Council was to develop a full petroleum policy. Pre-empting both the
Iraqi elections and the drafting of a new constitution, Allawi’s
guidelines specified that while Iraq’s currently producing fields
should be developed by the Iraq National Oil Company (INOC), all other
fields should be developed by private companies, through the
contractual mechanism of production sharing agreements (PSAs).(45)

Iraq has about 80 known oilfields, only 17 of which are currently in
production. Thus the Allawi guidelines would grant the other 63 to
private companies.

Allawi also added that:

New fields would be developed exclusively by private companies, with the policy ruling out any participation of INOC;(46)

The national oil company INOC, which manages existing oil fields, should be part-privatised;(47)

The Iraqi authorities should not spend time negotiating the best possible
deals with the oil companies; instead they should proceed quickly, agreeing
whatever terms the companies will accept, with a possibility of renegotiation
(e) later.(48)

Phase 3: Transitional Government and writing the
Constitution

The interim government was replaced in early 2005 by
the election of Iraq's new National Assembly, which led to the formation
of the new government with Ibrahim al-Ja’afari as Prime Minister. In
a move which no doubt assisted policy continuity from the period of
US control, Ibrahim Bahr al-Uloum was reappointed to the position of
Minister for Oil.

Meanwhile, Ahmad Chalabi, the Pentagon’s former favourite
to run Iraq, was appointed chair of the Energy Council, which replaced
the Supreme Council for Oil Policy as the key overseer of energy and
oil policy. Back in 2002 Chalabi had famously promised that "US companies
will have a big shot at Iraqi oil."(49)

By June 2005, government sources reported that a Petroleum
Law (f) had been drafted, ready
to be enacted after the December elections. According to the sources
– although some details are still being debated – the draft of the Law
specifies that while Iraq’s currently producing fields should be developed
by INOC, new fields should be developed by private companies.

In October 2005, a new Constitution was accepted in
a referendum of the Iraqi population. Like much of the Constitution,
the oil policy section is open to some interpretation. Apparently referring
to fields not currently in production, it states:

"The federal government and the governments of the producing
regions and provinces together will draw up the necessary strategic
policies to develop oil and gas wealth to bring the greatest benefit
for the Iraqi people, relying on the most modern techniques of market
principles and encouraging investment."(50)

There are two issues here. The reference to "market
principles and encouraging investment" indicates a clear direction of
travel, in terms of opening to private companies. Meanwhile the first
part of this clause, somewhat vaguely, tries to deal with the issue
of jurisdiction. However, while this states that the federal and regional
governments will work together, a subsequent clause states that:

"All that is not written in the exclusive powers of
the federal authorities is in the authority of the regions. In other
powers shared between the federal government and the regions, the
priority will be given to the region's law in case of dispute."(51)

Signing of contracts for extraction of oil and other
natural resources is not listed(52)
as one of the exclusive powers of the federal authorities – the implication
is thus that on new fields, it is the authority of the regional governments.

This situation is quite unclear, and is further muddied
by a last-minute deal, arranged just before the constitutional referendum,
that the Constitution could be amended in the first half of 2006, and
by comments by Zalmay Khalilzad, US Ambassador to Iraq, that "after
that, as Iraq evolves, so, too, will this charter evolve".(53)

In so far as the decision rests with Baghdad, the Oil
Ministry is keen to sign contracts as quickly as possible. According
to officials in the Ministry, their aim is to begin signing long-term
contracts with foreign oil companies during the first nine months of
2006.(54) In order to achieve
this goal, officials wanted to start negotiations with oil companies
during the second half of 2005, before a legitimate Iraqi government
is elected and in parallel with the writing of a Petroleum Law.(55)
This time frame means that contracts will be negotiated without public
participation or debate, or proper legal framework.

Meanwhile, the Kurdish authorities are even more impatient
to sign deals. In June 2004, the Kurdistan Regional Government (KRG)
signed an exploration and development deal with Norwegian company DNO.
In a clear sign of the tensions between Baghdad and the regions, the
Oil Ministry reacted by warning companies that if they signed deals
with regional governments, they would be excluded from contracts at
a national level.

Then in October 2005, the KRG signed a memorandum of
understanding (MOU) with K Petroleum Company, which is jointly owned
by the Canada-based Heritage Oil and the Kurdish company Eagle, to carry
out oilfield studies adjacent to the Taq Taq field in Kurdistan. Announcing
the deal, Heritage stated that

"Negotiations to formalize the MOU into a Production
Sharing Agreement(PSA) are scheduled to commence while the work program
is being carried out.KPC is confident these studies will translate
into a PSA, although there is no guarantee that a license will be
awarded to the Company."(56)

For the southern oilfields, the outlook is less clear.
In any case, regional governments of both Kurdistan and southern Iraq
would have far weaker bargaining power in negotiating with foreign oil
companies than the Iraqi Oil Ministry (or Iraq National Oil Company),
as they lack both the institutional experience and the consolidated
weight of handling the entire country’s resources. The likely result
would be more negative terms than could be achieved at a national level.

As noted above, only 17 of Iraq’s 80 known fields are
currently in production.(57)
As these 17 fields represent only 40 billion of Iraq's 115 billion barrels
of known oil reserves, the policy to allocate undeveloped fields to
foreign companies would give those companies control of 64% of known
reserves.(58) If a further
100 billion barrels are found, as is widely predicted, the foreign companies
could control as much as 81% of Iraq's oil; if 200 billion are found,
as the Oil Ministry predicts, the foreign company share would be 87%.

Given that oil accounts for over 95% of Iraq’s government
revenues(59), the impact of
this policy on Iraq’s economy would be enormous.

While the advantages of production sharing agreements
for multinational oil companies are clear, there is a severe shortage
of independent analysis of whether PSAs are in the short, medium and
long-term interests of the Iraqi people. Unfortunately the Iraqi people
have not been informed of the pro-PSA oil development plans, let alone
their implications, which have transformed so seamlessly from US State
Department recommendations into Iraqi government policy. This report
hopes to go some way towards redressing this balance.

Our analysis shows that production sharing agreements
have two major disadvantages for the Iraqi people:

1. The loss of hundreds of billions of dollars in
potential revenue;

2. The loss of democratic control of Iraq's oil industry
to international companies;

PSAs may also undermine an important opportunity
to establish effective public oversight and end the current corruption
and financial mismanagement in the Iraqi oil sector (see
Section 6).

PSAs generally last (with fixed terms) for between 25
and 40 years: thus once signed the Iraqi people would have to live with
the consequences for decades.

LOSING REVENUE: HOW MUCH WOULD PSAS COST THE IRAQI
PEOPLE?

In order to understand why foreign oil companies are
so keen to invest in Iraq, one needs to look at the economic outcomes
that would result from applying PSA contracts to the Iraqi oil sector.

We have produced economic models of 12 of Iraq’s oilfields
that have been listed as priorities for investment under production
sharing agreements. We do not know yet what terms Iraqi contracts might
contain (that will not be known until they are signed – and possibly
not at all, if they are not disclosed to the public). Therefore we have
taken contractual terms used in other comparable countries, and applied
them to the physical characteristics of Iraq’s oilfields (based on data
from the Iraqi Oil Ministry, the US Government and respected industry
analysts such as Deutsche Bank – see Appendix 3).
This process allows us to project the cashflows to the Iraqi state and
to foreign oil companies, under a range of assumptions (such as oil
price).

Specifically, we look at terms used in Oman and Libya
(both having comparable physical conditions to Iraq) and Russia (the
only country with any PSAs which has reserves at all comparable in scale
to Iraq’s). The terms recently applied in Libya are widely viewed to
be among the most stringent in the world. We have then compared the
results with expected revenues of a nationalised system, administered
by state-owned oil companies.(g)

Using an average oil price of $40 per barrel, our
projections reveal that the use of PSAs would cost Iraq between $74
billion and $194 billion in lost revenue, compared to keeping oil development
in public hands.

This massive loss is the equivalent of $2,800 to $7,400
per Iraqi adult over the thirty-year lifetime of a PSA contract. By
way of comparison Iraqi GDP currently stands at only $2,100 per person,
despite the very high oil price.(60)

It should be noted that these figures relate to only
12 of Iraq’s more than 60 undeveloped fields. Iraq has identified 23
priority fields on which to potentially sign contracts in 2006.(h)
Thus when the other 11 fields are added, along with a further 35 or
more later, and especially other fields yet to be discovered (recall
that Iraq’s undiscovered reserves may be as large or even double the
known reserves), the full cost of the PSA policy could be considerably
greater.

We have been deliberately conservative with our assumptions.
Our assumptions and methodology are outlined in Appendix
4.

Both the corporate lobby group ITIC (see section
3) and the British Foreign Office have argued that foreign investment
can free up Iraqi government budgets for other priority areas of spending,
to the tune of around $2.5 billion a year.(61)
Although technically true, this is deeply misleading – as the investment
now would be offset by the loss of revenues later.

Amazingly, in ITIC’s report advocating the use of PSAs,
the economic impact is only examined up to 2010(62)
– ignoring the fact that any foreign investment must be repaid.(j)
It is as if one took out a bank loan but only considered the economic
impact prior to paying it back!

Photo: Greg
Muttitt
The use of PSAs could deprive Iraq of $190 billion of revenue

In contrast, in this report, we look at the impact of
PSAs over the whole length of the contract. Economists and indeed oil
companies compare investments using the process of 'discounting’, and
the concept of 'net present value’ (NPV). NPV is a measure of what the
later income or expenditure would be worth if they were received or
incurred now (See Appendix 2).

When looked at in these terms, far from 'saving’ the
government $8.5 billion of investment (the whole investment over several
years, in 2006 NPV), these contracts will cost Iraq a (2006) NPV of
$16 - $43 billion, at a 12% discount rate.(k)

Our assumed oil price for these calculations is $40
per barrel. The oil price is currently fluctuating around $60 per barrel,
and there is an argument that structural factors, such as increasing
demand in China and India, mean that oil prices are likely to stay at
this level – which would make our $40 assumption conservative.

However, the oil price is notoriously difficult to predict.
We therefore also look at the models at a higher price of $50 and a
lower price of $30 per barrel. Here the models show that Iraq would
lose $55 to $143 billion at $30 per barrel, while if the oil price averaged
a higher $50 per barrel, Iraq would lose far greater revenues of $94
- $250 billion, compared to the nationalised model.

MASSIVE PROFITS: HOW MUCH DO THE OIL COMPANIES STAND
TO GAIN?

Our economic model has also been used to calculate the
key measure of oil project profitability - the Internal Rate of Return
(IRR) (see Appendix 2) - which the oil companies are
expected to make. This provides another measure of whether PSAs represent
a fair deal for Iraq.

Profitability varies according to the size of the oil
field, so we have based our projections on three different fields which
(in Iraqi terms) are typical small, medium and large oil fields.

Our figures show that under any of the three
sets of PSA terms, oil company profits from investing in Iraq would
be quite staggering, with annual rates of return ranging from 42% to
62% for a small field, or 98% to 162% for a large field. This
shows that under PSAs, Iraq's loss in terms of government revenue will
be the oil companies’ gain.

By way of comparison, oil companies generally consider
any project that generates an IRR of more than a 12% to be a profitable
venture. For Iraqi oil fields, even under the most stringent PSA terms,
it is clear that the oil companies can expect to achieve stellar returns.

Even at prices of $30/barrel, profits are excessive
on all fields, with any terms, ranging from 33% on a small field with
stringent terms to 140% on a large field with lucrative terms. At $50/barrel,
the profits are even greater, ranging from 48% to 178%.

LOSING CONTROL: THE DEMOCRATIC COST OF PSAS

Iraq's democracy is new and weak. Having suffered decades
of oppression by Saddam Hussein, Iraq's institutions and civil society
need time to develop and mature. In this situation many Iraqis may feel
that they do not wish to immediately lock their country into any
single model of oil development over the long term. Unfortunately this
is exactly what Iraqi politicians, under US and UK pressure, appear
to want to do.

As we saw in section 2, in
theory PSAs would allow the Iraqi state to retain ownership and control
over their oil resources. However, in practice they will impose severe
restrictions on current and future Iraqi governments for the full lifetime
(25-40 years) of the contract.

PSAs have four key features that will in practice limit
and remove democratic control from the Iraqi people:

They fix terms for 25-40 years, preventing future
elected governments from changing the contract. Once a deal is signed,
its terms are fixed. The contractual terms for the following decades
will be based on the bargaining position and political balance that
exists at the time of signing – a time when Iraq is still under military
occupation and its governmental institutions are weak. In Iraq’s case,
this could mean that arguments about political and security risks in
2006 could land its people with a poor deal that long outlasts those
risks and is completely unsuited to a potentially more stable and independent
Iraq of the future.

Secondly, they deprive governments of control over the development
of their oil industry. PSA contracts generally rule out government
influence over oil production rates.(63)
As a result, Iraq would not be able to control the depletion rate of its
oil resources – as an oil-dependent country, the depletion rate is absolutely
key to Iraq’s development strategy, but would be largely out of the government’s
control. Unable to hold back foreign companies’ production rates, Iraq
would also be likely to have difficulty complying with OPEC quotas which
would harm Iraq’s position within OPEC, and potentially the effectiveness
of OPEC itself. The only way to avoid either of these two problems would
be for Iraq to cut back production on the fields controlled by state-owned
oil companies, reducing revenues to the state.

Thirdly, they generally over-ride any future legislation
that compromises company profitability, effectively limiting the government's
ability to regulate. One of the most worrying aspects of PSAs is
that they often contain so-called 'stabilisation clauses’, which would
immunise the 60-80% of the oil sector covered by PSAs from all future
laws, regulations and government policies. Put simply, under PSAs future
Iraqi governments would be prevented from changing tax rates or introducing
stricter laws or regulations relating to labour standards, workplace
safety, community relations, environment or other issues. One common
way of doing this is for contracts to include clauses that allocate
the 'risks' for such tax or legislative change to the state.(64)
In other words, if the Iraqis decided to change their legislation, they
would have to pick up the bill themselves. The foreign oil company's
profits are effectively guaranteed.

Fourthly, PSAs commonly specify that any disputes
between the government and foreign companies are resolved not in national
courts, but in international arbitration tribunals which will not consider
the Iraqi public interest. Within these tribunals, such as those
administered by the International Center for Settlement of Investment
Disputes in Washington DC, or by the International Chamber of Commerce
in Paris, disputes are generally heard by corporate lawyers and trade
negotiators who will only consider the narrow commercial issues and
who will disregard the wider body of Iraqi law. As the researcher Susan
Leubuscher comments, "That system assigns the State the role of just
another commercial partner, ensures that non-commercial issues will
not be aired, and excludes representation and redress for populations
affected by the wide-ranging powers granted [multinationals] under international
contracts."(65) They may also
– especially if connected to bilateral investment treaties – make a
foreign company’s home state a party to any dispute, thus enabling that
country to weigh in on the company’s behalf.

This loss of democratic control is illustrated by
the case of BP’s Baku-Tbilisi-Ceyhan (BTC) oil pipeline, which is being
built from the Caspian Sea to the Mediterranean. This project is governed
by a Host Government Agreement, some of whose legal provisions are comparable
to those in PSAs.

In November 2002, the Georgian Environment Minister
said she could not approve the pipeline routing through an important
National Park, as to do so would violate Georgia’s environmental laws.
Both BP and the US government put pressure on the Minister, through
then President Shevardnadze. The Minister was forced first to concede
the routing with environmental conditions, and then to water down her
conditions. Part of the reason for her weak bargaining position was
that two years earlier Georgia had signed the Host Government Agreement
for the project, which set a deadline for environmental approval within
30 days of the application and stipulated that the contract had a higher
status than other Georgian laws. The environment laws the Minister referred
to were irrelevant. Ultimately, on the day of the deadline, the President
called the Minister into his office, and kept her there until she signed,
in the early hours of the morning.(6)

Shortly after Shevardnadze was overthrown in a 'rose
revolution’ in November 2003, new President Mikhail Sakashvili commented,
"We got a horrible contract from BP, horrible"(67)
– but he could not change it.

MULTINATIONAL COMPANIES FAVOUR COMPLEXITY

Another feature of production sharing agreements is
that they are the most contractually complex form of oil contract. PSAs
generally consist of several hundred pages of technical legal and financial
language (often treated as commercially confidential). It is their complexity,
not their simplicity, which is advantageous to oil companies.

The simplest form of oil fiscal system is the royalty
(defined as a percentage of the total value of the oil), which can be
seen as a company paying the state for its oil – effectively 'buying’
it. This is used in most concession agreements, and sometimes in PSAs.
In comparison with production sharing formulae, it is very clear what
the state should receive from royalties – a fixed percentage of the
value of oil. As long as the number of barrels extracted is known, and
the oil price, it is easy to work out what royalty is due from the oil
companies.

However oil companies dislike royalties and prefer
systems based on an assessment of profits, such as PSAs. The reason
is that they want what they call 'upside’ (i.e. opportunities for greater
profits) – ways they can reduce their payments, rather than being subject
to a fixed level of payment for oil extracted.

Under profit-based systems, revenue is based on the
profit remaining when the oil companies’ production costs have been
deducted from the total revenue. As such, they depend on complex rules
for which costs can be deducted, how capital costs are to be treated,
and so on. The more complicated the system, the more opportunities there
are for a company to maximise their share of the revenue by sophisticated
use of accountancy techniques. Not only do multinational companies have
access to the world’s largest and most experienced accountancy companies,
they also know their business in more detail than the state they are
working with. Consequently a more complicated system tends to give multinationals
the upper hand.

For example, in the Sakhalin II project in Russia,
the complex terms of the PSA resulted in all cost over-runs being effectively
deducted from state revenue instead of from the Shell-led consortium’s
profits. During the planning and early construction of the project,
costs inflated dramatically. In February 2005, the Audit Chamber of
the Russian Federation published a review of the economics of the project,
finding that cost over-runs, due to the terms of the PSA, had already
cost the Russian state $2.5 billion.

Although three PSAs were signed in the mid 1990s in
Russia, they have been the subject of extreme controversy ever since.
The changing view of PSAs in Russia in general also illustrates the
loss of democratic control inherent in PSAs – if the government or political
climate changes, the terms of a PSA cannot change to reflect new priorities.
PSAs generally last for between 25 and 40 years. In Russia’s case, the
rush to privatise in the early 1990s is now being questioned – but with
the PSAs already in force it is impossible to rectify mistakes.

The Sakhalin II PSA is an example of a special type
of PSA, which is growing in prominence. In such PSAs, the sharing of
'profit oil’ is based not on a fixed proportion, but on a sliding scale,
based on the foreign company’s profitability. The state receives only
a low proportion of profit oil (or in the Sakhalin case, none) until
the company has achieved a specified level of profit. Thus, states are
deprived of revenue, while corporate profits are guaranteed. (See
Appendix 1).

IRAQ WOULD FARE NO BETTER

In theory, Iraq may be able to negotiate PSAs with
much more stringent terms than those used elsewhere in the world. As
noted above, we do not know what exact terms Iraq might adopt if it
uses PSAs. Iraq could also, in theory, avoid some of the more draconian
legal clauses outlined above.

However, we have also seen that there are a number
of structural features of PSAs which are likely to act against Iraq’s
interests, whatever the terms. Helmut Merklein, a former senior official
of the US Department of Energy, explains this based on the concept of
economic rents – the excess profits of oil production (after deducting
production costs and a reasonable return on capital):

"For all the sophistication and the bells and whistles
these contracts have, … they all have two basic flaws, which make
them less than perfect in terms of capturing rent. They are subject
to distortions through petroleum price fluctuations in world markets,
and they generally fail to provide the host country with its proper
rent if the field turns out to be greater than expected. Various triggers
in those agreements reduce the host country’s exposure, but they never
really eliminate it."(68)

The generation of rents is a feature of oil production.
Because of oil’s sheer value, its extraction generates profits beyond
what is normally expected on an investment. These rents should belong
to the country that possesses the oil resource. However, Merklein’s
point is that PSAs cannot – in unpredictable economic circumstances
– deliver the country its fair share of the rents, and inevitably tend
to give foreign oil companies excessive profits at the country’s expense.

To the flaws identified by Merklein, we would add
the long-term and restrictive nature of PSAs, that their terms are fixed
as negotiated in a situation which – one hopes – will not persist in
Iraq; and that they also place legal constraints beyond the issue of
revenue-sharing, as we have seen.

In some countries, circumstances in the oil sector
may favour investment through a mechanism such as PSAs, in spite of
these disadvantages – such as where fields are offshore, risk capital
for exploration is required, or the country lacks technical competence.
In Iraq, however, these conditions do not apply, and given the country’s
huge oil wealth, it does not need to accept the negative consequences
of PSAs.

On top of these structural flaws in PSAs, there are
grounds to doubt whether the specific terms Iraq might achieve would
be any better than in other countries, despite Iraq’s enormous oil reserves.
The key issue here is bargaining power: the Iraqi state is new and weak,
and damaged by the ongoing violence and by corruption, and the country
is still under military occupation.

In fact, rather than negotiating a more stringent
PSA deal than elsewhere, the oil companies will inevitably wish to focus
on the current security situation to push for a deal comparable to –
or better than – that in other countries in the world, while downplaying
the huge reserves and low production costs which make Iraq an irresistible
investment.

Indeed, precisely this point is being pushed by the
oil companies and their governments. The corporate lobby group ITIC
attempts to invert conventional economic logic, by implying that there
is greater competition among oil-producing countries than among private
companies:

"Although Iraq’s potential petroleum wealth is enormous,
the government still faces competition from other countries offering
petroleum rights to investors. … Investors, too, are competing for
access to attractive petroleum deposits but competition among them
may be limited if the project in question requires scarce expertise
or depth of financial resources."(69)

Thus one of ITIC’s key recommendations is that Iraq
"offer to companies profit potential consistent with the risk they bear".(70)

Their argument that countries, not companies, must
compete is especially perverse given the high oil price, and the wide
recognition of supply constraint: that there is a shortage of access
to reserves, not of access to capital.

Similarly, the US government’s development agency
USAID has advised the Iraqi authorities that

"Countries with less attractive geology and governance,
such as Azerbaijan, have been able to partially overcome their risk
profile and attract billions of dollars of investment by offering
a contractual balance of commercial interests within the risk contract,
one that is enforceable under UK and Azeri law with the option of
international arbitration."(71)

If Iraq follows that advice, it could not only concede
a contractual form which is not in its interests, but specific terms
which radically understate the country’s attractiveness to the international
oil industry. Along with much of its future income, Iraq could be surrendering
its democracy as soon as it achieves it.

6. A better deal:
Options for investment in Iraq’s oil development Back
to top

A central question for Iraqi planners and politicians
is how to invest in the country's oilfields – revenues from which will
provide the central plank of the Iraqi economy for the foreseeable future.
In the last section we saw, by looking at common practice elsewhere
in the world, that investment through production sharing agreements
(PSAs), would be likely to come at considerable cost to Iraq.

A RADICAL DEPARTURE

Much as their proponents like to claim that PSAs are
standard practice throughout the world’s oil industries, in fact International
Energy Agency figures show that just 12% of world oil reserves are
subject to PSAs, compared to 67% developed solely or primarily by
national oil companies.(72)
Thus it is far from inevitable or necessary that PSAs must be used in
order to obtain investment in Iraq’s oil development.

PSAs are often used in countries with small reserves;
however the nationalised model is almost exclusively used in all countries
with very large oil reserves.

The use of PSAs in Iraq would represent a major departure
from common practice among the large oil producers of the region. Iraq
and three of its neighbours (Saudi Arabia, Iran and Kuwait) are the
world’s top four countries in terms of oil reserves, with 51% of the
world total between them.(73)
None of them use any form of foreign company equity involvement in oilfields.

Looking further afield, these four Gulf states together
with the United Arab Emirates, Venezuela and Russia, hold 72% of the
world’s oil reserves. These latter three all have some foreign involvement
in their oil industry, although both Venezuela and Russia are currently
drawing back from it, following unsuccessful expansions in foreign investment
in the 1990s. Of these seven countries with major oil reserves, only
Russia has any production sharing agreements.

In the Russian case, three PSAs were signed in the
mid 1990s; they have been the subject of extreme controversy ever since
due to the poor deal the state has obtained from them, and it now looks
unlikely that any more will be signed.

OPTIONS FOR INVESTMENT

One argument that is deployed by proponents of PSAs
is that Iraq has no other option to generate the capital investment
needed to rebuild and expand its oil industry.

This is simply not true. In fact Iraq has at least
three options for generating investment in its oil industry, without
giving away its revenue and control over the industry:

1. Direct investment from government budget.

2. Government / state oil company borrowing from
banks, multilateral agencies and other lenders.

3. Investment by international oil companies using
more flexible and equitable forms of contract.

It is not the role of this report to advocate any
particular structure for the Iraqi oil industry, nor to advocate for
or against the use of foreign investment. That decision rests with the
Iraqi people. However, in this section we briefly explore each of these
options, all three of which are superior to PSAs in terms of consequences
for the Iraqi economy and people.

Photo:
Greg Muttitt
After 50 years of rip-off by foreign companies and over 20 years
of war, Iraq needs the right policies to develop its oil industry.

First, it should be stressed that there is considerable
technical competence among Iraqis themselves and foreign companies are
not required to manage the industry. Indeed, the most successful period
in the history of Iraq’s oil industry was between nationalisation in
1972 and the start of the first of Saddam’s wars with Iran in 1980.
Freed up from the foreign interference that had unhappily characterised
Iraq’s previous petroleum history, the Iraq National Oil Company moved
forward confidently and effectively: between 1970 and 1979, INOC increased
production from 1.5 million to 3.7 million barrels per day and discovered
the four super-giant fields West Qurna, East Baghdad, Majnoon and Nahr
Umar, and at least eight giant fields.

In some areas, the state of Iraqi knowledge may not
be the most up-to-date, because of the sanctions era. However, this
is easily solved within any of the above models by employing specialist
companies under short-term technical service contracts to provide drilling
and production expertise when required. Thus what is at issue is how
capital is obtained, not skills.

OPTION 1: FINANCING FROM GOVERNMENT BUDGETS

The simplest model would be for the required investment
to be provided each year out of government budgets. This is quite possible
and appropriate in Iraq’s case, because in contrast to many other countries:

The development cost is low when compared to the return;

As a consequence, the payback period is very quick;

Since there are considerable proven but currently undeveloped oil reserves,
risk to capital is very low (as no exploration is required for immediate
field development). In the longer term, Iraq will explore but even this
is relatively cheap and low-risk.

Iraq's investment requirement is expected to peak at
around $3 billion per year.(75)
This is well within the range of current budgetary allocations: the
2005 Iraqi oil investment budget is $3 billion76 (out of a total Iraqi
budget of around $30 billion).

Furthermore, within at most three years from the start
of development, revenues from new production would well exceed the ongoing
investment requirements, and could therefore provide this finance. In
other words, at worst Iraq would have to invest $2.5 – 3.0 bn of its
existing budget for three years.

One argument commonly advanced in favour of foreign
investment in Iraq’s oil is that it would save government budgetary
expenditures for other priority areas. For example, the British Foreign
Office argued in 2004, in a Code of Practice issued to the Iraqi Oil
Ministry:

"In the absence of a very high oil price, Iraq would
only be able to finance this investment [in oil development] itself
if it could secure a very generous debt reduction deal and was prepared
to make substantial cuts in government expenditure in other areas. Given
Iraq's needs, it is not realistic to cut government spending in other
areas, and Iraq would need to engage with the International Oil Companies
(IOCs) to provide appropriate levels of Foreign Direct Investment (FDI)
to do this."(76)

In other words, if Iraq pursued the option of direct
financing, the amount of money invested from the government budget would
no longer be available for schools, hospitals, roads etc. Economists
say that this capital has an opportunity cost.

However, the use of discounting techniques (see Appendix
2) is precisely designed to allow for the opportunity cost of capital.
In the previous section, we saw that, having considered this opportunity
cost by discounting, the Iraqi government is still better off investing
its own money. The (2006) net present value lost by the Iraqi state
as a result of adopting the PSA policy would be between $16 and $43
billion, at 12% discount rate.

This shows that, in purely economic terms, the policy
is bad for Iraq. However, the choice of what development path to follow
– whether to develop more quickly now, or to build steadily for the
long term – is ultimately a political one. As such, this decision should
be made by the Iraqi people; but it should be made with a full understanding
of the economic implications.

In the previous section, we found that companies could
expect rates of return on their investment of between 42% and 162%,
depending on the field characteristics and the PSA terms. These rates
of return can also be seen as the cost of the capital to the state if
Iraq decides to use the PSA financing route.

When looking at it in this way, it is helpful to put
all 12 fields together and consider them as a single investment. In
this case, we get 'company’ internal rates of return of:

Libya PSA terms: 75%

Oman PSA terms: 91%

Russia PSA terms: 119%.

The financial structure of PSAs versus bank loans are different, so these
are not directly equivalent to bank interest rates. However, by comparison
with bank rates, we can see that the cost of PSA capital would be huge
and could not justify the political considerations outlined above.

THE NEED FOR TRANSPARENCY

Ensuring that Iraq's oil wealth benefits the majority
of Iraqis is not only a question of the contracts themselves.
Appropriate development also depends on good governance.

There are very few oil-producing countries that
have managed to prevent corruption in their oil sectors, and Iraq
is no exception. Indeed, during the three decades of national
control over the industry, Iraq’s oil wealth was used to sustain
a brutal dictatorship and its internal security apparatus, to
personally enrich Saddam Hussein and his family, and to finance
devastating wars with Iraq’s neighbours. Meanwhile, corruption
became endemic at all levels of Iraqi officialdom.

Corruption is already a problem in post-Saddam
Iraq. Investigations by US and international agencies into the
financial operations of the Coalition Provisional Authority and
Iraq's interim governments have concluded that billions of dollars
have been lost due to corruption, theft and inadequate accountability.
The vast majority of that money, estimated to be at least $4 billion,
was derived from Iraq's oil income, which was meant to be invested
in the reconstruction of the country.(85)

Whether Iraq’s oil is held in the public or the
private sector, good governance and effective democratic institutions
will be essential. In order to prevent the emergence of another
Saddam, it is particularly important to curb the discretionary
power of the executive over oil income and expenditure. It is
also necessary to ensure that adequate oversight powers are given
to appropriate government bodies and that transparency is enshrined
in law.(i) Furthermore,
all oil income and expenditure must be included in a transparent
and accountable budgetary process. Auditors should report to parliament
and parliamentarians should be able to call ministers and senior
officials to account. No national reserve fund should be allowed
to be used as a "slush fund".(86)

These challenges are enormous in Iraq. However,
the insistence by the United States, the oil industry and their
allies on constitutional and contract terms favourable to foreign
investors with minimal state regulation, is likely to hinder,
not help, transparency and accountability.

Although civil society around the world is now
pressing for disclosure of contracts, with some initial successes
(ii), confidentiality
remains the norm. Minimum requirements for any form of contract
must be the prohibition on non-disclosure clauses and the publication
of the contracts themselves.(87)
Even then, PSAs present serious difficulties: as this report has
already shown, their complexity makes them notoriously difficult
to monitor.

The attitude of multinational oil companies can also be unhelpful.
Corruption problems often arise from the 'ultra-presidential’ status of
the executive and Iraq Revenue Watch warns:

"Foreign influence also has had a hand in promoting
ultra-presidential systems. During the 20th century, companies
mainly preferred to deal with one "negotiator," either the president
or his representatives, and the executive branch in many resource
rich countries grew all-powerful as oil rents flowed through it.
As foreign oil companies engage in more business with Iraq’s nationalized
oil industry, Iraqis must be vigilant to the potential role of
those companies in encouraging an ultra-presidential government."(88)

The emerging lesson from the growing body of evidence
of the 'resource curse’ – where countries with natural resources
such as oil suffer high levels of corruption, and even (paradoxically)
economic decline, is that before massive influxes of capital or
oil revenue, it is necessary to have in place the institutions
to manage them and an economic base that is broader than sole
reliance on the oil economy.(89) In this context, it is precisely the speed of Iraq’s opening to
the oil multinationals, with rapid change and a lack of clear
governance structures, which is likely to create the conditions
for corruption and economic failure.

i For
more on this, see www
.pblishwhatyoupay.org - website of the Publish What You Pay
coalition of over 280 civil society organisations. ii Such as in Azerbaijan – legal agreements
were unavailable until civil society pressed for them to be published.
After which BP posted its agreements on its website www.caspiandevelopmentandexport.com

OPTION 2: GOVERNMENT / STATE OIL COMPANY BORROWING

An alternative option would be for state oil companies
(or the government) to borrow the money, either as

1. loans from banks, using future oil production as
collateral;

2. concessionary loans from multilateral agencies, such
as the World Bank; or

3. the issue of government bonds.

As with the direct funding option above, the low cost
of development and quick payback make this quite an attractive option.

Helmut Merklein, a former senior official of the US
Department of Energy, comments that the foreign investment/PSA approach,
"would be like securing a $300 loan by pledging a fully paid-for $300,000
residence as collateral. In contrast he notes:

"With that kind of collateral, there will be no shortage
of commercial or governmental (bilateral or multilateral) credit institutions
eager to supply the required capital needed to rehabilitate oil production
in Iraq."(78)

Muhammad Ali Zainy, an expert on Iraqi oil at the Centre
for Global Energy Studies, looks specifically at the Majnoon field as
an example, noting that:

"If INOC [Iraq National Oil Company] borrows the $3
billion amount to be repaid over 20 years at 10% interest compounded
annually, the debt service (principal and interest) would be around
$352 million/year, or around $1.6 per barrel per day. … [Combining
this capital cost with production and transportation costs] the total
FOBb cost to INOC would be $3.5 per barrel. If this oil is sold at
$35 per barrel, the rent to INOC would be $31.5 per barrel. With these
prices and costs, it should not be very difficult for INOC to borrow
from the banks, with incremental oil as the collateral."(79)

What is unclear at this stage is how such an approach
would interact with Iraq’s existing national debt – the largest (relative
to GDP) of any country in the world.

The International Monetary Fund is expected to issue
a Standby Agreement, setting out conditions with which Iraq will have
to comply in order to receive some debt relief, by the end of 2005.
It is unknown whether this will place restrictions on Iraq’s future
borrowing. The IMF recognises the need for investment in Iraq’s oil
sector but the IMF is also infamously keen on pressuring countries to
privatise their industries.

There is similarly a question of whether commercial
lenders would be deterred by Iraq’s high level of debt. Their decision
will depend in particular on what agreements are made on repaying the
existing debt. In any case, the points made by Merklein and Zainy, above,
are convincing: given the huge scale of the available rentsc, and the
corresponding potential collateral (from future oil production), it
would seem to be more a question of negotiating the right terms than
of finding a lender willing to participate.

Furthermore, in light of the priority given by the international
community to rebuilding Iraq, lower-cost loans from the World Bank or
other multilateral agencies should also be an option.

There is a very strong case, being made by the Jubilee
Iraq network (80) and others,
that the bulk of Iraq’s debt should be treated as odious debt. That
means that the debt was incurred by Saddam Hussein without the consent
of, and not for the benefit of, the Iraqi people. Rather, he used it
to fight wars and to finance internal repression. Thus, it is argued
that the people of Iraq bear no legal or moral responsibility to repay
that debt.(81)

Were this argument to be accepted by the Iraqi authorities,
international borrowing could be quite straightforward. As the Wall
Street Journal pointed out:

"We wouldn't blame (Iraq’s) leaders if they decided
that some of those financial obligations are indeed odious. And given
that this is such an extreme case, international lenders probably
wouldn't hold it against them for long."(82)

In any case, it is noteworthy that even the strongest
advocates of PSAs – including corporate lobby group ITIC, the British
government, and Iyad Allawi – seem to accept that borrowing is an option.(83)

OPTION 3: MORE EQUITABLE AND FLEXIBLE CONTRACTS?

Iraq’s neighbours Iran, Kuwait and Saudi Arabia have
recently allowed some limited foreign investment in their oil and gas
industries, although in a very different way from PSAs.

They have used alternative contractual options such
as risk service contracts, buyback contracts or development and production
contracts.

Each of these contractual forms allows a foreign company
to provide investment in an oil development, but gives it no direct
interest in the oil produced. The oil remains with the state and the
company is paid as the state’s contractor. As such, these contracts
can be seen as modifications of the technical service contract to allow
investment.

All three give operatorship of the field to a foreign
company, but with much more limited rights, and in the case of buybacks
and DPCs, for a much more limited period of time than PSAs. Importantly,
in all three contract types, the foreign company does not have the opportunity
to make excessive profits, as it is paid either a fixed fee or a fixed
rate of return.

Obviously any form of external financing has a cost.
Indeed, even with the borrowing option above, Iraq will have to carefully
consider the terms of any loan, and its future implications(l)
. Iraq should be careful not to tie its hands, either through contracts,
or through collateral arrangements. The challenge will be to weigh the
advantages of freeing up government funds against the cost of the finance.

We have seen that if Iraq’s oilfields are developed
by foreign companies under PSAs, the cost to Iraq’s economy will be
enormous. We have also seen that PSAs would give considerable control
away to the multinationals for many decades.

It is in these respects that buyback, risk service or
development and production contracts may be preferable for Iraq. For
the same reasons, the oil companies argue that such forms of contract
are not sufficiently appealing to them (not profitable or wide-ranging
enough) to justify their investment.(84)
In large part, this is a negotiating position – inevitably, companies
will downplay their interest in order to get a better deal.

Even if it is true to some extent, Iraqi negotiators
should not be pushed into accepting terms that are not in Iraq’s interests.
In the previous section of this report, we have shown how damaging PSA
deals would be; in this section, we have tried to show that other options
are available. If the oil companies will not sign fair contracts, then
Iraq can develop its oil industry without them.

ALTERNATIVE CONTRACT TYPES

Algeria has made significant use of a mechanism known as the
Risk Service Contract. In this model, a foreign
company invests capital, and when production begins is reimbursed
their costs (from oil sales), plus generally a fixed fee per barrel
of oil produced. (iii) The company can thus increase its profits by
increasing the rate of production; on the other hand, the company
carries the risk that the venture will fail (especially where
exploration is involved). This model may also be used in Kuwait’s
opening to investment of four of its northern oilfields (Project
Kuwait), which is still under parliamentary debate.

In the 1990s, Iran developed the Buyback
Contract,
which it has applied on a number of oilfield investments. This is very
similar to the risk service agreement, but is generally for a shorter
period – commonly 5 to 7 years of production (following 2-3 years of
development) – after which the state oil company becomes the operator
of the project and keeps all revenue. The fee is paid in oil rather than
cash and is calculated as a percentage of the capital invested.
Thus the company obtains an agreed
rate of return on its investment, provided a sufficient rate of
production is achieved (although, again,
the company carries the risk that little or nothing will be produced).
Returns are generally 15-24%.

In the late 1990s, Iraq under Saddam Hussein developed
a new form of contract along similar lines, known as the Development
and Production Contract. In this, a company would develop
and operate an oilfield for a fixed period – commonly 12
years. After that, operatorship would be passed to the state oil
company, but with the foreign company providing services under
a Technical Service Agreement (often for a further 15 years),
during which the company also has a right to buy oil – either
at market price or at an agreed discounted rate.

All of these contract types limit the profits that can be extracted
by foreign companies, so guarantee
more effectively the state's income, and do not cede the same
degree of sovereignty as PSAs.

iii The term "risk service
contract" is slightly ambiguous – it is alternatively
revenues are shared (in cash), rather than production itself.

We have seen in the preceding chapters that, under the
influence of the US and the UK, powerful politicians and technocrats
in the Iraqi Oil Ministry are pushing to hand all of Iraq’s undeveloped
fields to multinational oil companies, to be developed under production
sharing agreements. They aim to do this in the early part of 2006.

The results for Iraq would be devastating:

Iraq would lose an enormous amount of revenue (making it conversely highly profitable for the foreign companies);

The terms of the contracts would be agreed while the
Iraqi state is very weak and still under occupation, but be fixed for
25-40 years;

PSAs would shift decisions on any disputes out of Iraq
into international arbitration courts, where the Iraqi constitution,
body of law and national interest are simply not relevant.

Yet, Iraq has other options for obtaining investment in its oil sector, including:

Direct financing from government budgets;

Government/state oil company borrowing; or

Less damaging contracts with multinational oil companies, such as buybacks
or risk service agreements.

These decisions should be made with the full participation
of the Iraqi people, not in secret by unaccountable elites. Care should
be taken not to take major irreversible steps that would later be regretted.

In a Production Sharing Agreement (PSA), a foreign
company provides capital investment. In Iraq’s case, in the medium term
this will include drilling and the construction of infrastructure, but
not exploration – as Iraq has around 65 known but undeveloped fields.

The first proportion of oil extracted is then allocated
to the company, which uses oil sales to recoup its operating costs and
capital investment – the oil used for this purpose is termed 'cost oil’.
There is often a limit to what proportion of oil production in any year
can count as cost oil.

Once costs have been recovered, the remaining 'profit
oil’ is divided between state and company in agreed proportions.

The company is often also taxed on its profit oil
and, to add further complexity, there may also be a royalty payable
on all oil produced. Often a bonus is paid to the government on signing,
and sometimes on start of production. However, such bonuses are generally
small compared to the revenues themselves.

AN EXAMPLE OF HOW PSAS WORK

To illustrate how a PSA works, let us consider a hypothetical
case which includes all of the above elements, with the following terms.
This example illustrates the mechanisms involved, and is not based on
terms that would be appropriate to Iraq.

Profit oil split: 60 state : 40 company

Royalty: 15%

Profits tax: 40%

DIAGRAM A1.1: SPLIT OF REVENUES IN
A HYPOTHETICAL PSA

In the diagram above, we show how these elements are
divided. Royalties are charged as a percentage of the total value of
the oil. Cost oil is then deducted. In this case, we assume that development
and production costs amount to 40% of the total revenue (this is determined
by the physical and economic characteristics of the oilfield, rather
than by the PSA terms). The remaining 45%, after deducting royalties
and cost oil, is divided between state and company 60:40. The company’s
share of profit oil is then taxed.

Putting all of these together, the company receives
50.2% of total revenues including the recovery of its costs. As the
profits of the field are 60% of the revenues (after deducting the 40%
costs) – thus the state take is 82% of the profits; the company’s take
(share of profits) is 18%.

Sometimes the state also participates as a commercial
partner in the contract, operating in joint venture with foreign oil
companies as part of the consortium (as in Libya, for example). In this
case, the state is considered as a shareholder in the 'company’ – so
the 'company’ share of profit oil is split between the state and private
investors. If the state has a 50% participation share, it provides 50%
of the capital investment, and receives a further 50% of the company
share of profit oil (after the state-company split).

A newer form of PSA divides 'profit oil’ not in fixed
proportions, but on a sliding scale, intended to reflect the profitability
of the venture.a The theory is that the more profitable a venture, the
quicker costs are recovered, and so the more is available for the state.
The sliding scale can be based on rates of production (90),
'R’-factors (defined as the ratio of cumulative receipts to cumulative
expenditures) or the company’s internal rate of return.(91)

The argument for rate-of-return style PSAs is based
on allowing the state to capture a reasonable share of profits, but
in practice this advantage can be outweighed by other consequences:

1. the investor’s profits are effectively guaranteed,
by denying the state a fair share of revenue until the specified profit
has been achieved;

2. while the specified level of profits is assured,
this does not preclude the investor from obtaining much higher profits
(at the more normal, lower share of profit oil);

3. it is in the investor’s interests to inflate costs
(a process known as 'gold-plating’), especially if they can sub-contract
operations to another company in the same group (for example, from one
Shell subsidiary to another Shell subsidiary) – as the subcontractor
profits from their work, the project operator still profits according
to the PSA, and the state gets little or nothing.

Investments in the oil industry generally last over
a period of decades. A large amount of capital is invested up-front,
and then income is received over the life of the project.

When modelling such investments, it is important to
consider the time value of money. A specified amount of money
is worth more now than it is at some later date – even neglecting the
effect of inflation.a This is because money received now can be invested,
and so will earn extra profits.

For example, if I have £100 now, and invest it in
a bank account with 10% interest (0.1 in decimals), I will get £10 interest
in the first year. After one year, I will have:

100 + (0.1 x 100) = 100 x 1.1 = 110.

In the second year, I will get £11 interest (10% of
£110) – this includes interest on the original £100, and also on the
first year’s interest – known as compound interest. After the
second year I will therefore have:

100 x 1.1 x 1.1 = £121.

Extending this logic, in five years’ time, I will
have:

100 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 = £161.

This is written 100 x 1.15 (100 times 1.1 to the power
of 5). Thus, if this level of interest is available, £100 now is worth
61% more to me than £100 in five years’ time.

DISCOUNTING AND PRESENT VALUE

Put the other way round, money is five years’ time
is worth less than it is now – to consider its equivalent value today,
we have to discount it.

When we compare different transactions at different
times, we discount all future amounts to what they would be worth now,
allowing for the time value of money. What they would be worth now is
called their present value.

DISCOUNT RATE

The effect time has on the value of money depends
on what return would be available were the 'now’ money to be invested.
So if we could only get 5% interest, £100 now would be worth 100 x 1.055
= £128 in five years’ time.

The annual rate at which today's money would grow
– and hence the rate at which 'later’ money must be discounted in our
model – is called the discount rate.

Reversing the calculations above allows us to work
out present values. £100 in five years’ time has a present value of:

100 / 1.055 = £78 at a discount rate of 5%; and

100 / 1.15 = £62 at a discount rate of 10%.

The oil industry commonly uses a discount rate of
12% in real terms, or 15% in nominal terms (allowing for inflation).

The discount rate can be considered to be the opportunity
cost of capital. By investing capital in a project, the investors have
lost the opportunity to invest it elsewhere. Therefore they will not
invest in the project if the capital could be invested elsewhere more
profitably (e.g. in another project, or in a bank account, or in bonds
or stocks). The discount rate is the return they would expect to get
by investing elsewhere.

NET PRESENT VALUE (NPV)

So when we consider the profitability of a capital-intensive
project such as an oilfield development, we have to look at discounted
values. Rather than simply counting the profit as
minus , we look at the net present value (NPV)
of the project, which is defined as [sum of present values of receipts]
minus [sum of present values of expenditures].

Net present value is always given with a specified
discount rate – if the discount rate is not stated, the NPV is meaningless.

We can illustrate this with a simple example of a
five-year project, with the following cashflow:

Year

Expenditures

Receipts

1

75

0

2

20

30

3

10

40

4

10

40

5

10

40

This project has total expenditures of 125, and total
receipts of 150. But to see whether it is profitable, we need to use
discounting.

Year

Net cash flow (NCF)
(= Receipts less expenditures)

Present value of NCF
at 12% discount rate

1

-75

-75

2

10

= 10 / 1.12 = 8.93

3

30

= 30 / 1.122 = 23.92

4

30

= 30 / 1.123 = 21.35

5

30

= 30 / 1.124 = 19.07

This project has a net present value of £ -1.73, at
a discount rate of 12% (the total of the right-hand column) - so is
not considered profitable.

Note that profitability depends on what discount rate
we use. At a discount rate of 10%, the same project would have a net
present value of £ +1.91 so it becomes profitable at this discount rate.

INTERNAL RATE OF RETURN (IRR)

The other concept that is used to assess profitability
of oilfield projects is internal rate of return (IRR). This
is defined as the discount rate at which the project NPV would be reduced
to zero.

IRR can only be worked out numerically – by trial
and error. For the project above, we can see that the IRR is somewhere
between 10% and 12%. However, modern spreadsheets programmes can calculate
IRR automatically. Using a spreadsheet, we can find that in fact the
IRR for this project is 11.03%.

The investor considers the project profitable (and
will decide to invest in it) if the IRR is greater than the discount
rate. The higher the IRR, the more profitable the project.

As noted in section 4, Iraq’s
emerging oil policy is that the Iraq National Oil Company will continue
to operate the oilfields which are currently in production, while all
new fields will be developed by private companies through production
sharing agreements.

In March 1995, the Ministry of Oil (under the Saddam
regime) listed 25 new fields to be earmarked for priority development
if sanctions were lifted: 11 in the south, 4 in central Iraq and 11
in the north. The list was presented by Ministry officials including
Thamer al-Ghadban, who subsequently became "chief executive" of the
Ministry during the first few months of the occupation in 2003, and
then Oil Minister in the Interim government of Iyad Allawi.

These fields are listed below, with summary data.
This data has been taken from recent reports by the US Department of
Energy's Energy Information Administration, Deutsche Bank, the Iraqi
Ministry of Oil and BearingPoint strategic consultants for the US Agency
for International Development (USAID).

In June 2005, the Ministry of Oil announced that it
was seeking discussions with multinational companies on the development
of 11 oilfields in the south of Iraq.(96)
Although they did not list the fields, we assume that it is the same
11 southern fields listed above.

The Khurmala and Hamrin fields in the north are now
being developed through technical service agreements, signed respectively
with Turkish company Avrasya in December 2004 and with the Canadian
OGI in March 2005, leaving just 9 fields in the north, in two groups.

The impact of the proposed Production Sharing Agreement
policy on Iraq’s revenue will of course depend on the terms of any PSA,
as well as on physical circumstances, especially development and production
costs, and the oil price.

In this appendix we consider a number of possible
terms used in other countries, and apply them to a 'base case’ physical
scenario; we then test sensitivity to variations in the physical scenario.
The aim of the exercise is to examine how PSA performance compares to
the current nationalised system.

Theoretically the state’s percentage of net revenues
from a PSA – known as state take – can range anywhere from 0.1% to 99.9%,
according to how the contractual terms are set. In practice, according
to Petroconsultants’ 1995 review of petroleum fiscal regimes, on economically
marginal oil fields, state take ranges from 25.1% in Ireland to 101%2(m)
in Syria, while on very profitable 'upside’ fields it ranged from 25.0%
in Ireland to 87.7% in Abu Dhabi. However most PSAs provide for a state
take of between 60 to 90%.

We have selected three different scenarios (Oman,
Libya and Russia)(n), with varying
terms, and then applied them to the physical characteristics of Iraq’s
oilfields, to consider their economic implications.

Oman was selected as, like Iraq, it has relatively
low-cost onshore fields, and is one of the only countries of the Gulf
region that actually uses PSAs.

Libya was selected as it has produced oil for many
decades, and has recently reopened to foreign investment following a
period of international sanctions. Libya’s most recent ("EPSA IV") terms
are widely considered within the oil industry to be among the most stringent
in the world, so might be considered a 'best case’ PSA for Iraq.

Russia was selected as it is the only country which currently uses PSAs
and has oil reserves which are remotely comparable in size to those of
Iraq. Like Iraq, Russia has had an oil industry for many decades. Russia's
PSAs were also signed during a period of rapid liberalisation following
major regime change. Indeed, there is substantial technical collaboration
between Russia and Iraq.

No tax (tax is paid only by the National Oil Company, from its share of profit oil).

No royalty.

Signature bonuses and state participation share were open for
companies to bid in an auction, with the contract going to whichever
company offered the highest share of production to the state (or
whichever offered the higher signature bonus if two companies bid the
same share). State participation shares of profit oil ranged from 61.1%
to 89.2% (average 81.5%), and signature bonuses from $1m to $25.6m
(average $8.8m). In applying Libyan-type terms to Iraqi oilfields, we
take these average bonuses and participation shares.

On top of the signature bonuses, further production bonuses
apply for each block. In our model, we take the bonuses of Libya’s
Block 54, which constitute: $5m when 100m barrels have been produced,
then a further $3m when each of 130, 160, 190, 220, 250,280, 310, 340
and 370 million barrels have been produced.

State provides no contribution to exploration costs, 50% of
development capital, and share of operating costs equal to its
participation share.

Profit oil is split according to production rate and 'R’ factor (ratio
of contractor’s accumulated receipts to accumulated costs). This varies
from block to block in Libya. For our analysis, we take the terms from
Libya’s Block 54, which does not consider production rate, but divides
profit oil according to 'R’ factor as follows:

'R’ factor

Contractor share

0.0 - 1.5

90

1.5 - 3.0

70

> 3.0

50

OIL FIELDS CONSIDERED

We now consider the economic impact on Iraq, using these
three sets of PSA terms.

For this assessment, we consider only the fields likely
to be opened soonest via PSAs: Halfaya, Bin Umar, Majnoon, West Qurna,
Gharaf, Nasiriya, Rafidain, Amara, Tuba, Ratawi, East Baghdad and Ahdab.
These are the priority fields identified for development in 1995 (as
listed in Appendix 2), excluding Hamrin and Khurmala which are now already
being developed, and also excluding 11 smaller fields on which full
data was not available.

PSAs could potentially be signed on all of these in
2006.

ECONOMIC MODELLING

To consider the economic impact of the proposed PSA
policy, we have constructed economic models of each of the twelve priority
oil fields listed in Appendix 3. The results are shown
in section 5.

We consider only oil, not gas, in this analysis.

All figures are in real terms (2006 prices) – i.e. with no inflation.

We assume that economic factors (including production
rates, costs etc.) are the same whether oil is extracted by the Iraq
National Oil Company or by foreign companies through PSAs. This
assumption is based on the technical expertise existing within Iraq’s
own oil industry, and its access to new technological resources through
technical service agreements.

We use a discount rate of 12%.

The analysis assumes PSAs are signed in 2006, followed by
feasibility and appraisal expenditures of $10 million in the three
subsequent years. Project sanction (and hence first development
investments) occur in 2009. First oil is achieved in 2011, at 30% of
the peak level, then rising steadily to peak in 2014.

Production profiles are based on the figures for reserves
and peak production cited in Appendix 2, with constant exponential
declines in production ranging from 3% for the largest fields (Majnoon,
W Qurna, East Baghdad) to 15% for the smallest (Ahdab). Similarly,
production plateaus range from zero (single peak) for the small fields
to over 20 years for the largest.

Development expenditures are based on those used by
PetroConsultants, adjusted according to the field size and production
rate, generally continuing until two years after the end of
peak/plateau production.

Iraqi oil experts estimate operating costs between $0.5(100)
and $1.5(101)
per barrel. We assume this to relate only to variable
operating costs; for our analysis, we take $1.0 per barrel. We add
fixed operating costs of 5% of development costs.

For simplicity, we do not include transport costs – thus the oil price
used is effectively the wellhead price. If transport costs $0.5 per barrel,
then the FOB oil price is $0.5 higher than the wellhead price.

(14) UK Secretary of State for
Foreign and Commonwealth Affairs, Government Response to Seventh report
of the House of Commons Foreign Affairs Committee, on 'Foreign Policy
Aspects of the War Against Terrorism', September 2004

(16) James McLaughlin (Iraq
Policy Unit, Foreign & Commonwealth Office), letter to Lorne Stockman
(PLATFORM), response to request under the Code of Practice on Access
to Government Information, 9 December 2004

(17) For more on ongoing US
influence in Iraq, see Herbert Docena, 'Shock and Awe' Therapy, Focus
on the Global South, April 2005

(37) US State Department, Future
of Iraq Project, Oil and Energy Working Group (Oil Policy Subgroup),
April 2003, published in Middle East Economic Survey, 'Iraqi oil policy
recommendations after regime change', 5 May 2003, pp.D1-D11

(46) "For new development of
undeveloped oil and gas fields, and for exploration, all of which must
start as soon as possible and in tandem with INOC's efforts, these should
be accomplished through private sector investment via competent international
… oil companies… However, these new ventures should specifically not
be allowed to partner with any state-owned enterprises, including INOC,
in order to ensure state impartiality and avoid the pitfall of state
interference in corporate enterprise management". [Cited in Middle East
Economic Survey, 'Allawi outlines new Iraqi petroleum policy: INOC for
currently producing fields/IOCs for new areas', 13 September 2004, pp.
A1-A4]

(47) "Eventually, in years to
come, INOC may be partially privatised through wide distribution of
ownership among Iraqis through public subscription" [ibid]

(48) "Should we spend months
and years trying to exact the last penny in negotiating the commercial
terms? I would suggest that there is no need to waste time. Time is
of the essence". [ibid]

(63) Like many of the other
details of the contracts, the extent to which this is a problem will
depend on the outcome of negotiations. However, experience elsewhere
suggests it will be difficult. For example, OPEC members Algeria and
Nigeria have consistently struggled, and largely failed, to rein in
foreign companies' production rates. Of the 11 members of OPEC, these
two (along with Indonesia, which has recently under-produced its quota
anyway, due to declining capacity) are the ones with the greatest level
of foreign oil company involvement. Similarly, when Iraq under Saddam
Hussein attempted to attract foreign investment in 1995, the Oil Minister
admitted in an interview with Middle East Economic Survey that guarantees
would have to be given to oil companies that they would be able to produce
at their desired level. [Dr Safa Hadi Jawad al_Habubi, interview with
MEES, 38:25, 20 March 1995, p.A5]

(64) E.g. in Azerbaijan's ACG
PSA [Article XXIII, clause 23.2]: "In the event that the Government
or other Azerbaijan authority invokes any present or future law, treaty,
intergovernmental agreement, decree or administrative order which contravenes
the provisions of this Contract or adversely or positively affects the
rights or interests of Contractor hereunder, including, but not limited
to, any changes in tax legislation, regulations, administrative practice,
or jurisdictional changes pertaining to the Contract Area the terms
of this Contract shall be adjusted to re-establish the economic equilibrium
of the Parties, and if the rights or interests of Contractor have been
adversely affected, then SOCAR shall indemnify the Contractor (and its
assignees) for any disbenefit, deterioration in economic circumstances,
loss or damages that ensue therefrom."

In the PSA for Shell's Sakhalin II oil developments
in Russia, Appendix E exempts the project from, amongst other laws,
the Russia Water Code which forbids discharge of flows and drainage
waters in spawning and wintering areas for valuable and protected fish
species and in habitat for Red Book protected wildlife and plant species.
Destruction of salmon spawning sites as a result of oil spillage is
a major concern in the project. Article 24 (f) also provides blanket
compensation for damage caused to Shell's profits: The Russian Party
shall compensate the Company for any damage caused to the consortium's
"commercial position" by "adverse changes in Russian laws, subordinate
laws and other acts taken by Government bodies after December 31, 1993
(including changes in their interpretation or their application procedure
by government bodies and by the courts in the Russian Federation)."

(74) Putting energy in the spotlight
- BP Statistical Review of World Energy June 2005

(75) Oil Ministry figures give
an investment requirement of $25 billion over ten years. In our economic
models, the investment peaks at $3.0 bn in 2012 (the fourth year of
development). However, in the models first oil is expected in 2011 -
thus this will contribute to the 2012 investment. The highest annual
net investment in the models is $2.3 billion, in 2011.

(78) Helmut Merklein, op cit.
In this comment, Dr Merklein is actually referring to the smaller cost
of rehabilitating production to pre-Gulf War levels; but the same applies
to the larger investment too

Also The Economist, 'Those odious debts', 18 October
2003: "The Iraqi debt problem highlights a huge unresolved flaw in the
international financial system. There is an overwhelming case, both
in terms of economic expediency and justice, for writing off most of
Iraq's debts, and doing so fast… It is clearly unfair to expect the
Iraqi people to pay for the reckless waste of the regime that brutally
oppressed them for so long."

(84) For example, ITIC, Petroleum
and Iraq's Future (op cit), pp.30-31: "For the most part, international
oil companies do not favor risk service contracts. Such contracts have
sometimes been accepted as an interim measure, or a cost of access,
on the route towards eventual creation of a PSA regime. Typically risk
service contracts offer relatively low returns and present difficulties
for companies in booking reserves." ITIC indicates reluctant acceptance
of development and production contracts, but indicates a strong preference
for PSAs

(89) See e.g. Striking a Better
Balance: The World Bank Group and Extractive Industries, Final Report
of the Extractive Industries Review Vol 1, pp.12-16 and 45-52

(90) For example, in Syria the
state's share of profit oil ranges from 79% for fields producing less
than 50,000 barrels per day, to 87.5% for fields producing more than
200,000 barrels per day.

(91) For example, in the Azeri-Chirag-Guneshli
PSA, the Azerbaijan state only gets 30% of the profit oil until the
BP-led consortium has achieved 16.75% rate of return - a comfortable
level of profits. After that, the state's share goes up to 55%. Only
after the consortium has achieved a 22.75% rate of return - a high level
of profits - does the state's share of profit oil go up to a more normal
80%. [ACG PSA, article XI, clause 11.6]

The Sakhalin II PSA goes even further. In that case,
the Russian state gets no profit oil until the Shell-led consortium
has achieved 17.5% rate of return. The state then receives just 10%
for a further two years, and then 50% until the consortium has obtained
24% rate of return, after which the state receives 70%. [Sakhalin II
PSA, section 14. For detailed analysis, see Ian Rutledge, 'The Sakhalin
II PSA - A production non-sharing agreement' (pub CEE Bankwatch Network,
PLATFORM, Friends of the Earth, Sakhalin Environment Watch, Pacific
Environment, WWF), November 2004]

(92) Some of these fields are
producing small amounts of oil, including Majnoon, West Qurna and East
Baghdad. However, their production is well below their potential, respectively
50,000, 250,000 and 20,000 barrels per day prior to the March 2003 invasion
[US DOE, op cit] - essentially amounting to minor development of small
parts of the fields. As such, they are commonly described as "undeveloped".
[See e.g. Mohammad Al-Gailani (MD, GeoDesign Ltd), 'Assessing Iraq's
oil potential', Geotimes, October 2003]

(93) Reserves figures are taken
from Deutsche Bank, Baghdad Bazaar - Big Oil in Iraq?, 21 October 2002,
p.12; and from US DOE, op cit

(c) During the final years of
Saddam Hussein's regime, Iraq tried to re-open its oil industry to foreign
capital. This process was highly political, and contracts were negotiated
with and awarded primarily to companies from UN Security Council member
countries Russia, China and France, in an attempt to win support for
the dropping of UN sanctions. A PSA deal was actually signed in 1997
- with Russian company Lukoil for the West Qurna field - but never implemented,
due to the sanctions. Ultimately, Saddam cancelled the contract. Disputes
still continue with the new Iraqi authorities as to whether this contract
has any validity. Saddam also signed a development and production contract
(DPC) with China National Petroleum Corporation for the al-Ahdab field
(also never implemented, and ultimately frozen), and came very close
to signing a PSA deal with French company Total, on the Majnoon field.
Negotiations also took place on various other fields for PSAs, buybacks
or DPCs (see section 6).

(d) Bob Morgan died as a result
of a rocket attack on his car in Baghdad, in May 2004

(e) In this, Allawi was being
highly unrealistic. Although contracts can allow a certain degree of
renegotiation, companies will not sign them if the potential for renegotiation
is substantive or meaningful.

(f) Following the agreement on
a Constitution, a Petroleum Law is the next step in defining how the
oil industry is to be run.

(g)We also ran the models with
the terms used in PSAs Qurna field in 1997 (which was never implemented,
outlined here.

(h) Of these, we were unable to
obtain full data on 11 fields projected production (and hence revenue).

(j) This omission compounds the
inaccuracy of ITIC’s assumption barrels per day – on this
point, see the section 6.

(k) We have used a 12% discount
rate, as the rate most commonly used in the oil industry. However, it
should be noted there is some debate among development economists as
to what discount rate should be used for public sector investments.
It is commonly argued that, since states can borrow capital at lower
interest rates than private companies, and since states do not invest
in the same way as companies (and so do not experience the same extent
of opportunity costs), the discount rate should be lower than for private
sector investments. For example, US public institutions use a discount
rate of 7%. Some economists even argue that states should apply a zero
discount rate, as the process of discounting undervalues expenditure
for future generations. A lower discount rate would mean a higher NPV
loss to the Iraqi state.

(l) See for example, the 'Drilling
into debt' report by Oil Change International, which finds that oil-producing
countries tend to experience major indebtedness.

(m)These figures are produced
by applying all the countries’ terms to the same hypothetical oilfields.
Clearly, the marginal field here would not be developed if found in
Syria, as it would be uneconomic – the company would make a net loss.

(n) We noted in section 6 that
no countries comparable to Iraq use PSAs – indeed we would argue that
PSAs are not appropriate to Iraq’s situation of plentiful, low-cost,
known fields. Thus there is no natural choice of country’s terms to
apply in this analysis. Therefore it should be noted that the Oman and
Libya PSAs are for exploration and production, and thus carry the exploration
risk that no oil will be found. As a result they give potentially more
lucrative terms to compensate for the risk of failure to find oil. The
short- and medium-term development of Iraq’s oil will be of the roughly
65 known but undeveloped fields, whereas new exploration (especially
in the Western Desert) will deliver longer-term development. However,
against the lack of exploration risk in potential early PSA contracts,
Iraq carries more political risk than any of these other cases. On the
other hand the Sakhalin II field (which like the Iraqi fields was known
before the PSA was signed) is offshore and hence higher-cost which may
be reflected in more lucrative terms for the company. However, the current
high political risk in Iraq could quite plausibly lead to similarly
lucrative terms.

The exception would be the PSA deal signed by Saddam
Hussein with Lukoil in 1997 for the West Qurna field which was never
implemented and was cancelled in 2002. We have not used these terms
as one of our three featured scenarios because of its unusual status.
However, we did test the model against those terms. The loss of state
revenue (undiscounted and NPV) is within the range of these three scenarios.
The company internal rates of return, remain high by international oil
industry standards (20%, 40%, 57% at $40/barrel) for the 3 fields we
examined in section 5) but at lower than the three featured scenarios
due to an unusually high $100 million up-front signature bonus. While
the bonus is small compared to the total value of revenue, the fact
that it is paid up-front impacts more significantly on the rate of return
(due to the time value of money - see Appendix 2). The context of this
decision was that it was signed during the sanctions era, when the regime
was desperate for up-front cash, but conversely keen to win Russia's
political support in the UN Security Council. In this sense it was not
a 'normal' PSA so we have not used it in our main analysis. The Lukoil
terms were not officially published, so in our test we used those reported
by the Middle East Economic Survey [11 November 2004 - 'Lukoil Seeks
West Qurna Development/Iraq Debt Deal'].

PLATFORM is an interdisciplinary organisation working
on issues of environmental and social justice. Founded in 1984, it specialises
in addressing the impacts of British oil corporations on development,
environment and human rights. www.carbonweb.org

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